Wednesday, March 31, 2010

TBTF isn't just Bad Policy, it's a Scam

Free money from the Fed, and bail-outs from various governments allowed US Bank employees to pull off a marvelous trick, thereby freeing them from the normal contraints of Capitalism. They paid out more in dividends than they made in each of the past 3 years: by $8B in 2007, $41B in 2008 and $30B in 2009. Net operating income (NOI) for the banks was $102B for 2007, $10B for 2008 and $17B for 2009. This is obviously unsustainable, and makes the crooks from the Tech Boom look like amateurs- while the Techies based their fraud on the greater fool theory, the Bankers simply paid off their owners, and gave themselves raises.

The streams here in the Northeast US today, following a solid 2 day rain, are akin to those of income enjoyed by US Banks- spilling over at record setting levels.

As promised yesterday when I detailed the obscene compensation of bank industry employees, today's musings will focus in more detail on US Banking sector incomes, expenses and the future of Too Big To Fail.

Banks always and everywhere make the bulk of their income from lending and the US sub-species is no exception to this rule. Bankus Americanus is, however, unique in a few regards. It is the only animal on the Endangered Species list whose dwindling numbers are a result of cannibalism. To wit, in just the past 15 years numbers have dropped from 12,604 to 8,012 but those that remain are fatter than ever. Additionally, (and somewhat more seriously) unlike most banks in history, in recent times non-interest income has risen to more than 50% of interest income, helped in part, by the termination of Glass Steagall restrictions.  Data: FDIC- all covered institutions, aggregated

Given the substantial compensation American Bankers receive one might expect the increased non-interest income to come via trading, investment banking or the recently allowed insurance and brokerage activities, but this is not the case. Service charges on deposit accounts earn US Banks more than trading, investment banking, insurance, or brokerage in every year for which I have data. The lowly paid back office workers, in other words, generate much more income than the highly paid traders.

Admittedly, as I learned at Chase, there are indirect benefits to having a trading desk (and other financial services). Trading, for example, requires a cash deposit which will not only generate its own set of fees but also increase lending by whatever multiple the bank deems prudent.

Regardless, in the aggregate, US bank trading profits (exclusive of employee expense) have never exceeded 10% of net interest income. And the banks haven't even begun to unwind their derivatives portfolios, an event which may well push the absolute value of trading income above that of interest income for a year or two. I suspect in the not too distant future the wisdom of bank trading will be seen as pure folly. The NIMBY (Not In My Back Yard) movement which drove, e.g. chemical processing, off to foreign lands will soon, I believe, drive trading from Banks.

Moving on to larger streams, the biggest line item in the FDIC's breakdown of non-interest income is obscurely titled "additional non-interest income." The FDIC defines this as:

 All non interest income of the bank not required to be reported elsewhere, including (but exclusive to): 
  1. Income and fees from the rental of safe deposit boxes;
  2. Income and fees from the sale of checks, money orders, cashiers' checks, and travelers' checks;
  3. Income and fees from the use of the bank's ATMs;
  4. Income from performing data processing services for others;
  5. Earnings on or other increases in the value of the cash surrender value of bank-owned life insurance policies;
  6. Rent and other income from Real Estate Owned.
Chalk up another win for the back office, and, better still, the electronic office. An inquiry with the FDIC informed me that ATMs (and related services) were some of the biggest earners at US Banks. How clever of Bankus Americanus. The advent of the computer and internet age led to price reductions in most industries, inspiring the then Banker in Chief Greenspan to proclaim a productivity miracle. Bankers, by contrast, increased their income.

Pause for a moment. Can you imagine the outrage if ATMs were outlawed and tipping a teller a few dollars each time one made a withdrawal became mandatory? Can you imagine how many people would suddenly get the urge to be a bank teller? Banks would then have no problem staying open 24 hours a day, just like the ATMs- and we might all enjoy a human voice saying, "Thank you for banking with us."

There's a lesson to be learned here. The aggregate data strongly suggests that bankers aren't smarter than they were 30 years ago, they are just more protected. Protection of the sector allowed a relatively small group of people to pay themselves huge salaries (and huger bonuses) while the bulk of bank income was derived not from their efforts but from normal bank services spared the ravages of tech sector cost cutting. The high priced guys are the one's who have generated the problems.

Returning to cash flows, income isn't generated for free. The network of ATMs required development (but shouldn't the patent protection for this have expired like those for pharmaceuticals?), installation, and continued service. Profits accrue only when incomes exceed expenses. Banks must borrow funds more cheaply then they lend them.

As interest income is the bulk of bank income, you would expect that interest expense (i.e. cost of funds) is the bulk of bank expense. Up until the past few years, this was true. In 1994, interest expense was $145B (interest income was $321B) while employee compensation was $70B. In 2009, interest expense was $145B (interest income was $541B) while employee compensation was $163B. Amazingly, less than 2 million bankers (actually the problem is caused by the top 10%) paid themselves more than they paid the 100s of millions of depositors for the use of their funds. They even paid themselves more than they paid the bank owners.

If this (taking new equity capital to pay off previous investors and line their pockets) sounds like a Ponzi scheme that dwarfs that of Mr. Madoff, then I've made my point.

This brings us to the bottom line. If the Banks are truly TBTF and Bank employees truly indispensible, Capitalism is well and truly dead and Banking no longer a job, but a religion. In Capitalism, shareholders, not employees are the ultimate arbiters of business. Once net income goes to zero or below, the business, in its current form, is on borrowed time.

Free money from the Fed, and bail-outs from various governments allowed US Bank employees to pull off a marvelous trick, thereby freeing them from the normal constraints of Capitalism. They paid out more in dividends than they made in each of the past 3 years: by $8B in 2007, $41B in 2008 and $30B in 2009. Net operating income for the banks was $102B for 2007, $10B for 2008 and $17B for 2009. This is obviously unsustainable, and makes the crooks from the Tech Boom look like amateurs- while the Techies based their fraud on the greater fool theory, the Bankers simply paid off their owners, and gave themselves raises.

Yesterday Paul Volcker said TBTF was "moral hazard writ large". He was wrong. It's a hazard before it happens. This has been going on for 3 years.

As with the Tech Boom, something has to give. The real sector in the US isn't recovering, in part because credit is just circling round in the financial markets, as was the case in the early 90s, but on a much larger scale today. Real sector borrowing rates (adjusted for tighter credit conditions) are still too high. Thus the residential mortgage problem is not going away, and likely to worsen now that the Fed is out of the game (for the moment at least) and a commercial mortgage problem is looming.  Unlike the early 90s, there is no RTC set up to recover money for the banks, and there's that problem of who really owns the mortgages to be solved.

At current price levels it will be years before the banks are back to whatever constitutes normal these days, and I don't think we'll have that much time. Unlike the 90s, we have a government debt roll-over problem. If Banking sector NOI is roughly zero again this year, will shareholders be willing to accept zero dividends? I doubt it. Absent a sudden recovery in the real sector, US Banks, like the Irish Banks, will soon find they need more money.

Barring an unlikely substantial reduction in employee compensation (a solution I highly recommend, rolling salaries back to 1999 levels would free up roughly $70B A YEAR for loan loss provisions), the banks could dilute their own shares (but only for so long) or try to raise more overseas equity, but the amounts would be limited, in the case of foreign investment, to less than a controlling stake. I can't imagine the US population or government allowing China to hold a controlling interest in Citibank or any other big BHC.

A $ devaluation policy would alleviate the mortgage problem but the subsequent rise in interest rates would likely ignite another, much larger problem in the 200+ Trillion dollar derivatives portfolios, and our foreign creditors would be none too pleased. Sadly for them, the Germen option of forced liquidation is that least desired by the powers that be. Devaluation, I suspect, is the only option- it just has to appear to be an accident.

Regardless, we'll likely soon discover that TBTF isn't just bad policy, it's a scam- the Tech Boom on steroids.

A note on aggregation: Sometimes this process makes it easy to miss the trees for the forest-some banks might have profitable trading desks but they get lost. Goldman Sachs comes to mind. Yet, during the crisis of 2008, GS would have gone the way of LTCM (for the same reason) but for their transformation into a BHC and the bail-out of other institutions (notably AIG) which kept payments flowing.  GS isn't much of a bank in the usual sense but an investment house.  They should not, in my view, have gotten the protection of commercial banks. 

A note on trading: This essay might leave readers with the notion that I'm against trading. I'm not. I trade.  I simply believe that for trading to provide the promised price discovery benefits, they must stand on their own as private sector businesses.

Tuesday, March 30, 2010

It's Good to be a US Banker (for now)

I remember the first time I saw a fellow trader get fired from Chase Manhattan. Sitting down at my desk in front of the green screens (this was before the invasion of computer terminals) I had my coffee in one hand and a phone in the other when a buddy sitting behind me whispered, "check out the security guards."

I looked around and saw two guys in uniform standing at attention near the elevators. I hadn't noticed them when I arrived, as I was reading the newspaper. "What's up with that?," I asked.

"Someone's getting fired," he responded.

The 35th floor of Chase was very quiet, I suddenly noticed.

A few minutes later another trader walked in, nose buried in his newspaper, on the way to his desk. The guards, one of whom carried a cardboard box, followed him and just before he reached his desk told him to pack his things in the box and come with them. He reached for a phone but the guard was quicker. "No calls," he said, "pack your stuff and let's go."

It was a scary scene, but on reflection, as I still had a job (I was later to be on the other side of this issue), it made me feel as if banking (at least on the trading side) was a place where Capitalism reigned. Perform and you get very well paid. Screw up, and you're fired.

Or so I thought.

I've spent much of the past 2 days downloading data from the FDIC (more on those details in my next post) and was amazed to discover the best uptrend in the financial markets is banking salaries and employee benefits. One look at the graph below and I realized Lloyd Blankfein must be right. Bankers are doing God's work (or at least being compensated as if).

the data is skewed somewhat higher from the late 90s on by the repeal of Glass Steagall

You might think, if Bank employees are doing well, the owners must be doing even better. If these banks were more privately owned I would agree, but they aren't. It's apparently much better to work for a big bank (smaller banks don't pay even their top guys that well, as I found drilling down in the data) than to own it, just ask the gang at Goldman. The graph of cash dividends isn't nearly as pretty (but you can't argue with any dividend for 2008 or 2009, given the recent crisis, if you're an owner).

If you aren't a bank share owner but simply a taxpayer hoping the Fed won't let the currency in which you're remunerated shrink in value, you can argue plenty.

Recent news headlines proclaiming the wondrous profit (of $7B, not enough to pay salaries and bonuses of the top men at the big 5 US Bank holding companies) ready to be realized by the government with the sale of Citibank (brokered by these same bankers) miss the point. The Fed's balance sheet exploded to ensure that the Bankers who approved the loans which fomented the crisis could provision (inadequately, I suspect, as I'll discuss next time) against the losses and get paid handsomely for their shoddy work.

We'll all pay the price for that down the road and it may not be that far ahead.  Irish banks have gone back to their government for yet another infusion of capital.  Back here in the US, Elizabeth Warren of the TARP Congressional Oversight Panel is warning of an impending commercial real estate loan crisis.

When the next crisis hits, (not too long now, I suspect) the Bankers won't need a TARP, they'll need some flak jackets.

As Paul Volcker said today, the banks must face a credible threat of closure.  Ultimately the failing firm should be liquidated or merged. In all... it is a death sentence, not a rescue at the hospital.

Sunday, March 28, 2010

Capitalism is Dead: Keynesianism, Marxism and Communism are too!

The Obama administration is making final preparations to sell its stake in the New York bank (Citibank), according to industry and federal sources. At today's prices, the sale would net more than $8 billion, by far the largest profit returned from any firm that accepted bailout funds, and the transaction would be the second-largest stock sale in historyWSJ

John Kenneth Galbraith was once asked what he thought Nixon meant when he said, "We're all Keynesians now." Galbraith responded, in part, "He probably didn't know himself."  This might have been a joke.

I'm no expert on his views, but here's my attempt to succinctly present Keynesianism: 1) Capital (the means of production) is not the ultimate driver of economic growth, Demand is. 2) Demand can be manipulated by changes in government taxing and spending. 3) Economic growth can (and should) be maintained, if necessary, by such manipulations.

This interpretation of Keynesianism contrasts with that of Capitalism, which, I believe, in an ideologically pure sense holds that privately owned Capital, regulated solely by adherence to hard money rules of profit, loss and bankruptcy, is the driver of economic growth. Within that perspective, "Supply Side-ism" (if you will, a "child" of Capitalism) adopts the latter two elements of Keynesianism- capital can and should be manipulated by government intervention.

Using those definitions, with which, I'm sure, many will disagree, Capitalism is a rarely seen model. Supply Side-ism seems the most prevalent model in the west historically, and, recently throughout the world. US so-called Capitalists at the turn of the last century are, due to protective tariffs, better termed, Industrialists.

Within the past 30 or so years, however, the long time model of Supply Side-ism (sometimes leavened with Keynesianism, more often not) has fallen into disfavor and a new model has become preeminent in the US-Speculationism.

I'll borrow from Friedrich Nietzsche to continue: Have you not heard of that madman who lit a lantern in the bright morning hours, ran to the market-place, and cried incessantly: "I am looking for Capitalism! I am looking for Capitalism!"

As many of those who did not believe in Capitalism were standing together there, he excited considerable laughter. Have you lost it, then? said one. Did it lose its way like a child? said another. Or is it hiding? Is it afraid of us? Has it gone on a voyage? or emigrated? Thus they shouted and laughed. The madman sprang into their midst and pierced them with his glances.

"Where has Capitalism gone?" he cried. "I shall tell you. We have killed it - you and I. We are its murderers. But how have we done this? How were we able to drink up the sea? Is there any up or down left? Are we not straying as through an infinite nothing? Do we not feel the breath of empty space? Has it not become colder? Is it not more and more night coming on all the time? Do we not smell anything yet of Capitalism's decomposition? Capitalisms too decompose. Capitalism is dead. Capitalism remains dead. And we have killed it. How shall we, murderers of all murderers, console ourselves? That which was the holiest and mightiest of all that the world has yet possessed has bled to death under our knives. Is not the greatness of this deed too great for us? There has never been a greater deed; and whosoever shall be born after us - for the sake of this deed he shall be part of a higher history than all history hitherto." (with slight modifications)

Nietzsche's madman ranted about God, but I think his form is useful in the current regard. For Nietzsche, God died because man stopped understanding the word (a pun for theologists) and believing in its intended sense. Those who followed after God's death would need some new more powerful (Nietzsche hoped to find something more fundamental, or was he just mocking the attempt, it's hard to tell sometimes) controlling idea or chaos would ensue.

While I feel Nietzsche's argument form seems quite apt for the purpose of this essay, I don't share his faith (if such was the case) that we will find any more powerful, fundamental, controlling idea....and thus chaos ensues.

Consider the opening news item. The government bought a corporation not with the idea of controlling it- i.e., contra right wing talk radio, Obama is no Marxist- but with the idea of profiting from the speculative purchase.

To paraphrase Nixon, "we're all Hedge Fund managers now."

Capitalism is dead. Long live Speculationism.

Speculationism is the belief that economic growth is a function of money flows- not the hard money of decades past but money of indeterminate value which allows its quantity to be increased almost endlessly. Like Keynesianism and Supply Side-ism, note the implicit coordination of the state's power to create money and the providers of economic growth, finance.

The above, as an aside, is but an observation, not a critique. I do, however, find it funny that in the same way US Industrialists, protected behind tariff walls, fancied themselves "capitalists" decades ago, so too do today's Speculationists, protected by the Fed's ability to create money. Who are they kidding?

To wit, the US seems increasingly comfortable allowing its capital to move where it will (and it seems to want to move away) so long as Speculators can profit, not by running the company- i.e. controlling the means of production- but by betting on changes in its "market set" value. In Speculationism the term widget can, in the new textbooks, apply equally well to the things produced and the means of producing them.  The term capital itself has morphed and is no longer a reference to the means of production but rather to the money (sometimes previously referred to as financial capital, but this became repetitious) which, presumably drives it. 

Economic growth in the US is less and less a function of what we make (and how efficiently we make it) and increasingly a function of speculative profit. Thus, argue the Speculationists, the foolishness of Volcker's idea of separating speculative activities from commercial banking: Industry is dying, commerce is a small thing. The business of America is Speculation.

And they are right. Whether this will prove wise in the future remains to be seen, but things don't look good from where I sit.  I think we will miss Capitalism, and the capital (in its old sense) which has moved away.

p.s. Yes I waxed hyperbolic and didn't do justice with my definitions. This is but an essay, a word which means, to try (in this case to throw some ideas into the internet ether)

Friday, March 26, 2010

Helping the Fed Solve the Problem of Excess Reserves

The key to the game is your capital reserves. You don't have enough, you can't pee in the tall weeds with the big dogs. - Gordon Gekko

Ben Bernanke and the brain trust at the Federal Reserve have been working overtime trying to solve the problem of excess reserves in the US banking system. "How," they wonder, "can we drain these reserves from the system without destabilizing the markets?" Their fears of destabilizing markets are, I believe, justified, which seems odd given that the Fed, in the past, has been able to drain reserves, although the quantity drained was admittedly much smaller.

To the extent there is no way to drain these reserves without upsetting the markets the solution to the problem might not be one of action, but of thought. As Norman Vincent Peale said, "Change your thoughts and you change your world." Instead of trying to drain the excess reserves let's admit that they are not, in fact, "excess", but rather, "prudent", or even, as I suspect, "insufficient."

How do we determine if reserve levels are prudent, excess or insufficient? The determination is a process of thought. If financial assumptions about the future are perfectly accurate, there is no need of reserves- correctly valued assets will, under that head, always generate income sufficient to pay liabilities.

Reserves, then, are a safety measure in the event assumptions about the future are inaccurate- if assets are, in fact, not correctly valued. The more inaccurate prior assumptions of future events prove to be the wiser it would have been to increase reserves before the inaccuracies come to light.

The apparently resolved crisis in Greece seems a case in point (as, it seems to me, was the US crisis of 2008). The Greeks didn't simply decide, out of the blue, to borrow an additional 50 or 100 billion Euros, they, at certain levels of government, knew their fiscal position. Why then the crisis?

Simple. They made poor assumptions about either the value of their assets relative to liabilities (what economists call the primary fiscal balance) or the duration of the deceit which, in part, allowed them to borrow in sufficient quantities at favorable rates. In their case the latter seems more of an issue, as tends to be the case when crises "suddenly" manifest.

Like the homeowner who lied about his income to get a home or the Ponzi schemer who claims to own more than he does, the Greeks had been living on borrowed time. The question in that case about a crisis is not if but when.

Deceit, of course, is a loaded term as it connotes intent. Bernie Madoff is in jail because he admitted to such. In other instances a more appropriate phrase would be willfully ignorant. Those in charge hope for an outcome more objective, but equally educated persons deem unlikely, or impossible. Traders call this, talking your book.

Regardless of intent, the effects are the same. Reserves bridge the gap between projected and actual income relative to liabilities whether the gap is a function of deceit or ignorance (willful or otherwise). Sufficiently higher levels of reserves (other things equal) would have kept Mr. Madoff out of jail and obviated the Greek crisis.

Gordon Gekko had it right.

Returning to the issue du jour- the proper level of reserves in the US banking system- the difficulty of imagining a plausible future scenario with the reserves drained strongly suggests to me that current levels are minimally prudent. That is, if draining reserves would cause rates to rise, decrease real sector activity, or some combination thereof such that bank incomes wouldn't cover required payments then they shouldn't be drained.

Why then does the Fed seem so intent on draining? Perhaps they aren't as intent on draining them as some might think. Perhaps their intent is simply to maintain the illusion that the reserves are considered excess. If they told the world the level of reserves was considered prudent this would likely send a message that the financial state of US banks is not as healthy as otherwise advertised. This, in turn, might exacerbate future gaps between bank income and outflow, requiring even higher levels of reserves than currently exist, or, as was the case in Greece and with Mr. Madoff, precipitate a crisis.

Perhaps the only way to keep the real sector operating such that bank assets perform is to increasingly dilute the currency (since any increase in reserves would most likely be "borrowed" from the Fed as happened during the last crisis). Perhaps Mr. Kinsley's nightmare scenario of impending substantial inflation and even hyper-inflation is much nearer that truth than the Fed or Mr. Krugman would have us believe.  Perhaps the classification of reserves as excess has more to do with what the Fed wishes others (i.e. those who lend money to the US) to assume than what they assume, which edges ever closer to Greek deceit.

The Fed could, of course, prove me wrong by draining the reserves deemed to be in excess without precipitating a crisis.

I won't, however, be holding my breath.

Thursday, March 25, 2010

The Kins(l)ey Report (on Inflation)

One could, in a debate of US inflation prospects, discuss the virtues of issuing the currency in which your debt is denominated, and the ability of US political leadership to enact tough change counter-balanced, I think, by the magnitude of the debt in question relative to world GDP, and the actual history of US political leadership to enact tough change. But my aim is not (in this essay) a reasoned debate but a notice of the lack thereof.

If, like me, you're an official member of the pajama wearing blogger corps, you might be familiar with the recent debate over US inflation prospects between Michael Kinsley and Paul Krugman, et. al. If not, here's Kinsley's initial article, Krugman's rebuttal, Kinsley's retort, and Krugman's rebuttal of the retort.

Krugman's second rebuttal dripped with condescension, or so it seemed to me, recalling memories of school yard bullies. Those memories tempted me to begin this article with a quip about Krugman needing to pick on someone his own size......, but I'll use a different metaphor.

"Ouch!," you might be thinking, "that's a bit cruel."


So's this line from Krugman to Kinsley: "I’m tempted to get into an argument about whether it’s “bullying” to suggest that if you’re going to write about an economic issue, you might want to study it first. But what I really want to do is..."

Don't you love the artful use of the non-statement statement?

Aside from my belief that future events are more likely to follow some variation of Kinsley's nightmare scenario than Krugman's Japan model (about which, more here), the element of the exchange that inspired this post was Krugman's nasty dismissal of an apparently serious inquiry from one who apparently admires his views.

Kinsley's initial article contains statements like: "am I crazy?", "Every economist I admire, from Paul Krugman and Larry Summers on down, is convinced that inflation will remain low for as long as we can predict", "I can’t help feeling that the gold bugs are right", and "My fear is not the result of economic analysis. It’s more from the realm of psychology."

These are the words of a humble student searching for wisdom to quell his fears.

The wise Professor Krugman begins his rebuttal with: "Mike Kinsley has an odd piece in the Atlantic in which he confesses himself terrified about future inflation, even though there’s no hint of that problem in the real world."

You can almost see the sneering Professor holding up the student's paper in front of the class as you read the words (at least I could).

Using the tried and true nasty Professor trick of tossing about a bit of relevant jargon and a counter-example, Krugman expects Kinsley to slink back into his seat.

To his credit, Kinsley doesn't flinch.... much. He almost falls for the Professorial misdirection (debating whether a sudden 100% inflation shock is better than a Weimar hyper-inflation is like debating whether losing both legs is better than getting killed- I see your point, but I'll take none of the above) but then gets back on point, telling the Prof (in effect), "you didn't answer my question."

Why not inflation?

As Kinsley argued, the 70s demonstrated the US is not immune to inflation and Gold has risen from $275 to over $1000 during the past decade. Perhaps Kinsley's main confusion lies in his focus on the future tense, instead of seeing it as an ongoing issue.

Kinsley's search for the truth on inflation reminds me of Alfred Kinsey's search for truth on human sexual habits, which led to the publication of two books on human sexuality known collectively as the Kinsey Reports. Like Kinsley (or so it seems to me) Kinsey's search for truth battled with popular conceptions of what should (in some views) be, but wasn't.

In a sense Kinsey reported on what everyone (collectively) knew, but was afraid to say. The fear (perhaps, with the benefit of hindsight, somewhat justified) among then current opinion shapers was, in part, that open discussion would release the genie from the bottle. Hugh Hefner, of Playboy fame, credits Kinsey with opening his eyes to human sexual experience.

Krugman, in my view, is too smart an economist to dismiss outright the possibility of another significant inflation episode in the US, which may or may not be followed by hyper-inflation.

To use his phrasing, for those dismissing prediction of substantial US inflation, what is it about the US now that looks different to you from Thailand, Korea and Indonesia in say, 1997 (or Russia in 1998, or Iceland just recently)? Substantial public and private sector debt? Check. Huge expansion in the monetary base? Check. Large external debts and ongoing external deficits? Check. Increasing difficulties rolling over ever shorter term debt? Check. And yet each of those countries suffered, not multi-year hyperinflation, admittedly, but a sudden substantial (50-100% or more) inflation shock.

There are, admittedly, differences. As I wrote, I was using his phrasing and argument form. One could debate the virtues of issuing the currency in which your debt is denominated, and the ability of US political leadership to enact tough change counter-balanced, I think, by the magnitude of the debt in question relative to world GDP, and the actual history of US political leadership to enact tough change. But my aim is not a reasoned debate but a notice of the lack thereof.

Mr. Krugman might snidely respond to my snidely put question that the issue was hyper-inflation. I lived in Asia during their crisis and such shocks are worth worrying about even if hyper-inflation is avoided (besides, his use of Japan- a nation which self-finances, which seems to me a critical distinction- as counter-point suggests even moderate inflation is unlikely). Moreover, as Kinsley notes, who knows what policy makers will opt to do when the next crisis erupts. The history of the Bernanke Fed is not one of monetary restraint in a time of crisis.

I suspect that Krugman, not the economist, but the opinion shaper is, like those Kinsey battled, trying to keep the genie in the bottle- thus the Professorial dismissal instead of reasoned discussion of the issue. Inflation has both psychological and real world causes- when the two unite, the fireworks begin.

Perhaps, in a limited fashion, the Kinsley Report on Inflation will have a similar effect as Kinsey's, (then again maybe both should be seen as catalyst instead of cause) by bringing the debate into the open.

I wonder who the Hugh Hefner of Inflation will prove to be- perhaps Bill Murphy of GATA?

My advice to Kinsley is to have the courage of his convictions and buy some Gold, the price of which may have been as suppressed as reasoned open debate on US inflation prospects appears to be- both actions aim at the same effect.  I did (at $275 for Krugman's information) and I'm still holding.

Tuesday, March 23, 2010

US Industry, A Dim Bulb

Wang Jianwei, a graduate engineering student in Liaoning, China, was recently surprised to learn that he had been described as a potential cyberwarrior before the United States Congress due to a paper he published last spring- “Cascade-Based Attack Vulnerability on the U.S. Power Grid”.

My first thought on reading this news was that China would likely only resort to such a tactic in the event of actual war given that China and Asia in general generate (I couldn't resist) great profits from the US grid. Asian electronics exports wouldn't be of much use without a functioning grid in the US.

Further reflection on this topic recalled my days as emerging market economist; specifically one of the key bits of data in that field, electricity generation and consumption. Back then (the 90s) higher electricity consumption was seen as one of the few unalloyed goods in emerging economies- the more electricity an economy consumed the more it would grow.

Applying that view to the US, the graph below paints a picture of wonderful growth.

Yet, looks, in this case might be deceiving. While US electricity consumption has been growing it is being used to power a different mix of activities.

Until the mid 80s US Industry was the biggest consumer of energy, as the graphs below depict. Since the era of financial deregulation and industrial off-shoring (among other changes) Residential (all those new electronics exports from Asia) and Commercial (all those new office towers filled with people and computers in cubicles) use have continued to grow while Industrial use has lagged. US Industry uses roughly the same amount of power today as it used in the early 90s.

Meanwhile China's electricity consumption has been growing by leaps and bounds. The CIA's World Factbook lists China's electricity consumption as a close second to the US.

However, Chinese Industry currently uses, according to their Statistical Yearbook, almost 2.5 times as much electricity as US Industry. Current (2008) Chinese Industrial Electricity Consumption of some 2500B KwH is up from 883B KwH in 1999.

Suffice it to write that, if this data is a guide, the US is no longer the industrial workshop of the world.

Thursday, March 18, 2010

Will the US sell Manhattan?

Those who face insolvency, Mr. Schlarmann, a senior member of Germany's Christian Democrats, said, must sell everything they have to pay their creditors. Thus, he said, Greece, given its debt problems, should consider selling some of its uninhabited islands to cut its debt.

The headline in the Bild newspaper took the argument a bit further, "Sell your islands, you bankrupt Greeks - and the Acropolis too!"

I guess we might call this the Andrew Mellon approach to sovereign debt crises- liquidate, liquidate, liquidate, on a national scale. It's a strategy which, if Niall Ferguson's argument-which contains the wonderful line, US government debt is a safe haven the way Pearl Harbor was a safe haven in 1941- that the US, and other western nations, may soon follow Greece into crisis, proves prescient, might inspire calls for the US to sell some islands, like Manhattan.

Perhaps selling the island outright might be a bit much. Yet, while the Chinese Government isn't a fan of the Dalai Lama it might appreciate the Karmic touch of leasing Manhattan from the US for, say, 99 years. Imagine the road signs, "Now Entering New Hong Kong."

In a sense, assuming Wall St. and the NY Fed were included in the lease, it would be the ultimate "pump and dump"- temporarily stabilize the financial system, in large part with money from Asia, and then dump it, and the derivatives portfolios contained therein, on China. Why wait for the next financial crisis to go hat in hand to Asia. Let's sell Citibank at $4 instead of waiting for it to fall under a buck.

The world might even benefit from such an arrangement. Yesterday, Paul Volcker told the House Financial Services Committee that regulators, like the NY Fed, are unlikely to rein in excessive Wall St. speculation. If the Chinese get the NY Fed, and thus oversight of financial markets, their no-nonsense approach to dealing with corruption, which includes the death penalty, might help finance get back on the "straight and narrow." I'd love to see Lloyd Blankfein testify to the Chinese Communist Party.

A man can dream, can't he? And who knows what the future will bring. I doubt the Ottoman, Mughal and Manchu Empires could have imagined that the West would take over administration of their territories.

Fortunately, at least for Wall Streeters wary of Chinese justice, the German proposal fell on deaf ears. Yet, the seemingly intractable problem of many western governments' unsustainable debt levels remains.

Niall Ferguson argues that the problem is the welfare state- perhaps he should take on Keynes with a new book, The Economic Consequences of the Welfare State. I suspect, however, improper- to the extent such policies are seen as wise means of avoiding social unrest- welfare state funding is but a symptom of an apparently widely held view by many in both public and private sector positions of power that, in the words of Dick Cheney, deficits don't matter

War finance and Wall St. bail-outs played at least as large a part as welfare spending in US Federal Debt doubling since 2001.   Those bail-outs, in turn, were made necessary by Wall St.'s take on Cheney's wisdom, which they express as, too big to fail.

Contra Mr. Cheney, deficits, which add up to debt over time, do matter.  Contra Wall St., no insitution is too big to fail.  Both views are, in my view, effects of a broader issue.  There is no agreed upon method, barring adoption of island sales, for sovereign debt resolution. In decades past when nations retained currency sovereignty devaluation was always an option, and fear of devaluation kept investors on their toes. The more recent desire for supra-national currencies turns countries like Greece into states like California with very limited options.

If current trends continue, nations like Greece and states like California might simply be absorbed into larger bodies. Greece could become a special administrative region of the EU and California could become a district of the US Federal Government. Yet this would simply buy time, making the ultimate sovereign debt problem that much harder to resolve.

If the world is ever to reform global finance it will need, first and foremost, to agree upon a method of debt resolution applicable to all large institutions, public and private.   So long as those running large institutions feel there are no consequences to deficits, debt problems will continue to mount.  If we are going to use money to drive the world, we need to take it seriously.